Public risk number one

“The bottom line is that regulatory risk is huge.” This simple and straightforward statement, expressed by a fund manager at Infrastructure Investor’s recent LP Summit (IILP15), in New York, says a lot about a risk category that is neither simple nor straightforward.

The main reason regulation is a huge concern for investors is because it is subject to change. That in turn makes it difficult to predict. Even more concerning is when regulations are changed retroactively.

Perhaps the most recent example is the 90 percent tariff cuts Norway announced in 2013 for future gas transportation contracts. That triggered a wave of downgrades for private sector investors in Gassled, the country’s gas transportation network.

Njord Gas Infrastructure – a consortium of CDC Infrastructure and UBS Infrastructure – was hit the hardest, having its senior-secured index-linked bonds downgraded to junk status. Another consortium, Solveig Gas Norway, comprising Allianz Capital Partners, the Canada Pension Plan Investment Board and the Abu Dhabi Investment Authority, also saw its debt downgraded to BBB-.

While the initial shock may have subsided, the case continues to rattle the investment community since the Oslo City Court ruled against Gassled’s investors, which also include Selix Gas and Infragas, in September. In their lawsuit, through which they sought to recover estimated losses of $1.8 billion, the investors in the company claimed that the decision made by Norway’s Ministry of Petroleum and Energy (MPE) in June 2013 did “not have sufficient legal basis and must therefore be ruled invalid.”

The court ruled that the state had the right to make changes to its tariff system and in doing so did not violate Norwegian law, the constitution, nor European private property rights, as the plaintiffs claimed. However, the court acknowledged that “the MPE may be blamed for the lawsuit being instigated,” instructing each side – the plaintiffs and the defendant – to pay for their own legal costs as opposed to having the losing side pay the winner’s legal fees.

Njord Gas and Solveig Gas both announced on 30 October they have decided to appeal the decision, but developments to date have shaken investors’ confidence in the country, which until then was viewed as a safe haven.

Another example of retroactive regulatory change that has led investors to the realisation that regulatory risk is not limited to emerging markets is the numerous changes of heart Spain has had on its renewable energy regime. The changes Spain started making in 2010 as it sought to cut back generous feed-in tariffs for solar and wind projects it had introduced between the mid-90s and 2008 continue to be in the spotlight thanks to an ongoing arbitration process. On page 28, Infrastructure Investor provides an overview on HgCapital’s arbitration proceedings as it seeks, along with 14 other investors, to recover its losses.

Regulatory risk is often associated with political risk, as witnessed by the examples of Norway and Spain. As one panelist at IILP15 remarked, “politicians do not react to people who are happy; they react to people who are unhappy.” And that is why understanding the “climate” in which investors operate is so important.

“Quite often, we’ll work with the local utility commissioners to understand what’s driving their decision-making, knowing who those commissioners are upfront and what they have done historically,” this person said. “That has been a big part of what we’re doing [to mitigate regulatory and political risk].”

Another aspect that is closely linked to regulation and politics is headline risk. What kind of asset is being developed/built and what will the media say about it once it’s announced? What are the long-term repercussions?

One example is the Keystone XL pipeline, which has drawn a great amount of media coverage and a lot of controversy both in terms of support and opposition – and much political wrangling. It is inevitable that an infrastructure asset of that nature and scale will draw a lot of attention and result in regulatory action.

Panelists at IILP15 agreed that stakeholder engagement at an early stage is key. While there are many stakeholders involved in infrastructure, the main three are government, regulators and end-users.

“You’ve got to work with stakeholders,” one speaker, who has worked on a number of large infrastructure projects, said. “If you are involved in a major project, it’s likely you will get some exposure that you don’t necessarily want. This is where political risk forms and develops and that is very, very tough. So stakeholder engagement very early on is crucial.”

Another manager pointed out that understanding whether a regulatory risk is driven by political motivation or an effort to adjust a regulatory framework that is unfair or too vague is also important.

“Take the first Mexican toll roads privatisations,” the investor said, referring to the 5,000 kilometres of highway Mexico privatised between 1989 and 1994. Wanting to “recover” the assets as quickly as possible in order to avoid public backlash for privatising state property, the government sought short concession periods of 10-year terms on average. These short terms then put intense upward pressure on tariffs, forcing drivers to avoid using the toll roads.

The result was what rating agency Standard & Poor’s (S&P) has described as “a spectacular financial failure” that is “legend” According to S&P, toll rates in Mexico ranged from 16 to 62 cents per kilometre compared to a cost of between two and nine cents in the US. As a result, more than half of the toll roads reached less than 50 percent of the forecast volumes and in some cases, outturn revenues were 15-25 percent of base-case projections.

“That was a situation where the investors were the victims of a user-driven change, not a change that was based on politics or a regulatory scheme,” the investment manager said.

THE GOOD NEWS

Despite the tricky and complex challenges regulation presents, there is also an upside.

“One thing I would say about regulatory risk is that we see it as an opportunity as well,” one of the IILP15 panelists remarked. “We see that quite frequently when we look at renewable assets. Transitioning from coal generation to cleaner forms of energy, well-capitalised independent power producers are well-positioned to take advantage of the situation.”

Retroactive adjustments can also prove beneficial for investors.

On page 27, Infrastructure Investor takes a look at the amendments the European Commission has put forth, reversing its position on Solvency II in order to attract insurers to invest in infrastructure and asset-backed securities.

More positive developments are in store with the International Finance Corporation’s (IFC) recently announced plans to launch infrastructure debt separate accounts in an effort to attract more financing for emerging markets. What’s more, the IFC will bolster these separately-managed accounts by including credit enhancement mechanisms.

But whatever the outcome – good or bad – regulatory change is something investors must deal with as it will affect investments and financial outcomes. Difficult to predict and difficult to model, the most important tool in dealing with regulatory risk is in-depth due diligence.

For example, in the regulated utilities sector, cost of service in one country may look very different from cost of service in another country. Even when investing in the same sub-sector or in the same type of asset, no two investments are the same. This means a substantial amount of due diligence is required each and every time.

“The bottom line is regulatory risk, political risk is real. You have to be aware of it, you have to deal with it.” Period.